The ¥4.3 Trillion Japanese Government Earthquake Liability Cap: A Deep Dive Into The Mechanics Of Japanese Earthquake (Re)Insurance
After private Property and Casualty reinsurance companies got whacked on Friday on broad yet unquantified concerns about imminent losses, it is time for a deeper dive into the structure of how prepared Japan is to handle what are sure to be tens of billions in earthquake insurance claims. Using information from the Non-Life Insurance Rating Organization of Japan, we find that there is a clean distinction between the liabilities borne out by the private P&C sector and where reinsurance companies step in to fund losses on residential earthquake losses. A more nuanced breakdown comes from JPMorgan's Siddharth Parameswaran: "In Japan there is coverage provided for earthquake, through two distinct forms: 1) Coverage for losses of residences (governed by "Earthquake Insurance Law," It is covered by the domestic insurance industry and the Japanese Earthquake Reinsurance ("JER") Commission); and 2) Coverage for commercial losses internally insured and externally reinsured without involvement of the government." Of the former two, the first is far more important due to the pervasive losses of real estate in most of the northeastern coastal areas, which according to some estimates will reach in the tens of billions. The three numbers to keep in mind when evaluating potential liabilities are ¥115 billion (or $1.4 billion) which is the threshold for 100% private insurance coverage; next is ¥1.925 trillion ($23 billion), which is the limit on a 50/50 split between losses for private insurers and the JER (or $11.5 billion each), and lastly, ¥5.5 trillion through which 95% of all losses are borne by the government, and 5% by the private industry. In other words the total possible private losses to private P&Cs before reinsurance funding kicks in is about $16.5 billion, while the government stand to lose at most ¥4.3 trillion (or $52 billion). At this point losses are capped, and claims are pro-rated among all claimants. Should total losses surpass about $64 billion in real estate values (at various loss thresholds), claimants will have to settle for pennies on the dollar.
Below is a brief schematic of the general function of the JER from Goldman's Philippa Rogers:
Private insurance companies selling earthquake insurance inside Japan cede 100% of earthquake insurance to Japan earthquake reinsurer (JER). JER then reinsures risk with the government of part of the reinsurance liability.
- Buildings for residential use
- Household goods
- Earthquake, volcanic eruptions, tsunami
- Buildings: Total loss/Half loss/Partial loss
- Household goods: Total loss/Half loss/Partial loss
- Payment proportion of insurance claim (for the amount insured)
- Total loss: 100%
- Half loss: 50%
- Partial loss: 5%
- 30%-50% of amount insured of fire insurance to which it is attached
Limit of insurable amount
- Buildings: ¥50 mn
- Household goods: ¥10 mn
- Limit of total amount of insurance claim to be paid due to a single earthquake: ¥5.5 trillion
- Of which covered by the government reinsurance: ¥4.3 trillion
- Of which covered by the private sector: ¥1.2 trillion
A deeper dive in the JER mechanics comes from JPMorgan's Sid Parameswaran, who was in such a scramble to write this report he copied and pasted verbatim from Wikipedia:
Coverage for losses of residences
- The government of Japan created the "Japanese Earthquake Reinsurance (JER)" scheme in 1966 which governs insurance coverage for homeowners and storekeepers under the Earthquake Insurance Law. Under this law, homeowners can buy earthquake insurance from an insurance company as an optional rider to a fire insurance policy to cover both property damage to their dwelling as well as contents. The perils covered include fire, destruction, burying and washing-away caused by earthquake, volcanic eruption or tidal wave resulting there from (tsunami). The amount insured for earthquakes is limited to 30-50% of the amount insured under the comprehensive insurance policy, subject to a further limit of JPY50m for buildings and JPY10m for contents (source: Non-Life Insurance Rating Organization of Japan). There is a further scaledown based on the extent of the loss. A "total loss" will trigger a 100% payout of the insured amount for catastrophe, but it will be scaled back to 50% for a "half loss" and 5% for a "partial loss." As such, it appears that a majority of property losses are likely to fall on individuals themselves unless they suffer total loss.
- Insurers enrolled in the JER scheme who have to pay earthquake claims to homeowners share the risk among themselves and also the government, through the JER.
A visual summary of the flow of funds in the JER:
Next, JPM proves that using a 114 USDJPY exchange rate is perfectly normaly when copying and pasting from Wikipedia:
The JER (backstopped by the government) pays a much larger proportion of the claims if a single earthquake causes aggregate damage of over about 1 trillion yen (about US $8.75 billion) (source: Wikipedia). The maximum payout in a single year to all JER insurance claim filers is 5.5 trillion yen; if claims exceed this amount, then the claims are pro-rated among all claimants.
This insurance is NOT reinsured with overseas markets. It still could have some impact on global capacity. As a point of reference, Japan accounts for about 6% of world P&C insurance premiums (Net Earned Premium JPY6,971,058m, of which Foreign insurers have 5.6%, according to the General Insurance Association of Japan). At the end of March 2010, 46.5% of dwelling risk policies had earthquake insurance. As such, our initial thoughts are that the impact on global capital is likely to be limited.
Visually, this looks as follows:
Commercial losses can also be claimed, although here the private industry is entirely on its own:
Unlike householder’s coverage, commercial earthquake coverage is provided by private insurers and not by the government or a government-run fund. Earthquake coverage is an extension of the main fire policy which is available for an additional premium. However, due to very restrictive terms and conditions and the price associated with coverage many policyholders do not purchase this coverage – take-up levels have been described as “modest” in an Aon Benfield report (“When the Earth Moves: Mega-earthquakes to come?”). Further to this, coverage also is on a first loss basis rather than a full value basis, meaning the sum insured covered by the policy is less (potentially as little as 15%) of the full value of the property at risk.
In an extreme loss scenario, the combination of the modest take-up of earthquake insurance extensions and limited sum insured values, this restricts the loss to an insurance company.
JPM's conclusions appear rather spot on:
Implications for Global Insurance Industry
It appears to us that all the losses in Japan on residential houses are likely to remain within the country, given the nature of their coverage and the lack of use of external reinsurance. Japanese premiums account for about 6% of the insurance market as well, so the spillover impact on global insurance markets and capital from won't be inconsequential but will likely be limited. Also, given the limited coverage actually provided to households, it appears individuals (even those with insurance) will bare a substantial proportion of the costs.
In terms of commercial coverage, it appears from our exploration of industry publications that coverage is limited. As such, we conclude that two effects are likely to be seen: (a) some losses will hit balance sheets of global reinsurance companies, and (b) the losses, in our view, are unlikely to be large enough to cause an upturn in the premium rate cycle.
Broader Market Implications
There is likely to be liquidation of some funds by the JER and insurers in Japan to fund the earthquake. They probably would have invested some of their funds outside of Japan to avoid the negative correlation risk between their liabilities (Japan Earthquake) and their assets.
There also may be a further issuance of bonds by the Japanese government to fund their liabilities.
Companies in Japan and individuals in Japan may be bearing a significant proportion of the financial costs of the events (not to mention the human costs).
For what it's worth our take is that while international reinsurers, especially those from Europe, got hit badly on Friday, the market will realize that their liability is most in the commercial side. On the other hand, with potential losses of up to ¥4.3 trillion, the Japanese government itself will likely be forced to scramble to provide funding should Japan have pulled an "America" and left the reserve for the JER dangerously underfunded (obviously, should losses surpass this limit, the Japanese government will be facing many unhappy citizens, who suddenly realize they will face a discount on their insurance proceeds). That said, for Japan, a ¥4.3 trillion number is absolutely massive and should it have to pay out some or all of this amount, it will be left with no liability reserve for any future aftershock escalations. Unfortunately trying to glean some additional data on this critical variable proves impossible. From an overview of the "Earthquake Insurance System in Japan"
The frequency of occurrence of earthquake disasters is low, and besides, although they sometimes cause massive losses, it is impossible to predict when they will occur. Therefore, as for insurance premiums paid by policyholders, both insurance companies and the Government are obligated by the law to accumulate the total amount of such, excluding the portion of necessary expenses for contracts, as liability reserves in preparation for future earthquake disasters.
Additionally, it is obligated that all the investment profits from the accumulated liability reserves also be accumulated as liability reserves. Respective insurance companies are respectively accumulating the insurance premiums distributed in accordance with the respective burden of share as liability reserves, and are also accumulating all the investment profits from the accumulated liability reserves as liability reserves. The J.E.R. is managing and performing investment of these liability reserves in lump sum so as to pay insurance claims quickly to the victims of earthquake disasters. Investment of these liability reserves is limited to savings, national bonds, public bonds and corporate bonds, etc., since liquidity and safety of investment are required at the time of earthquake disasters.
The Government is accumulating the reinsurance premiums obtained and all the investment profits from the liability reserves as liability reserves. These liability reserves are accumulated separately from general accounting, under the Law concerning Special Accounts.
Alas, in an environment in which the world's biggest bank copies and pastes from Wikipedia, it is clear that few if any have any idea how this tragedy will play out, suffice to say that it will require a massive issuance of new paper at both the public and private sectors, most certainly accompanied by further rounds of quantitative easing on all sides of the Pacific (and Atlantic). Unfortunately, we expect sovereign paper volatility, especially that of Japan to add to the already chaotic picture come Monday when the market evaluates the implications of what has just transpired.
Full overview of the Japanese Earthquake Insurance System from the NIRO.
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